There are certain factors in investing in which we have little to no control. With this fact in mind, we have to give ourselves the best chance for success by strategically pinpointing the factors that we can control, and effectively utilize them to our advantage. The first and most important of these is asset allocation, which has been discussed on this blog and articles on the web, newspapers, and magazines ad nauseum. That is, stocks vs. bonds, value vs. growth, US vs. foreign, etc. Certainly, the propensity for articles to address these issues is with merit as asset allocation has, according to published studies, been responsible for nearly 90% of a portfolio's performance over the long-term (signifying the insignificance of market timing among other decisions).

The second key factor within our control that indexers love to stress is the ability to control fees - both fees with your financial advisor and fees within a fund as measured by its net expense ratio. Studies have shown that minimizing fees maximizes returns; even seemingly small differences (such as 0.4%) add up over the course of several years and you should do everything in your power to get the lowest cost investment to fulfill your asset allocation. The third significant decision within our control is the actual security selection. Although for indexers this point is not terribly interesting as we simply choose a fund that offers one of the lowest fees and fulfills the particular asset class we desire.

That brings me the fourth and final aspect of investments in which he have control over - minimizing taxes in our investments. We can do this by having a logical asset location - that is, which investments we choose to hold in taxable accounts and which we hold in tax-advantaged (401k, Roth IRA, etc.) accounts. While we certainly can't control what the government will do in the future to tax rates (and it would be a futile affair to attempt to predict such decisions), we can exploit how Uncle Sam deals with long-term capital gains and things of that nature tominimize the amount the US government takes from our investment gains. Small differences in taxes can compound in huge figures over the long-term and investors would be wise to consider the tax efficiency and placement of their investments to reduce their tax burden. Avoiding (or at least minimizing) certain taxes is one of the most important strategies to maximize long-term growth of one's investments, but is a topic that is, unfortunately, frequently glossed over in articles and discussions on portfolio management. As will be evidenced in this post with evaluations of after-tax final portfolio values based on asset location, the difference can be stark. This is a topic that shouldn't be brushed aside.

A Basic Primer on the Rationale

Your tax burden varies largely based on the type of investment as well as the investment style and turnover of the particular fund in question. In essence, the taxes you're responsible for depends on the taxable distributions and the rate on those. This can vary based on if dividends are qualified, how often a fund distributes capital gains, and other factors. The basic premise behind tax-efficient investing is to place your efficient investments in taxable accounts (and thus you won't lose as much to taxes) and your inefficient investments in tax-advantaged accounts (since you have no tax liability until distributions, or not at all if we're talking about Roth accounts).

As a general rule, bond funds are tax-inefficient because the gains they generate are all taxed as ordinary income and are subject to your marginal income tax bracket. (Although municipal bonds have no such restriction, but typically offer lower yields to compensate). REITs, likewise, are required by law to distribute at least 90% of their income as dividends, which is overwhelming at the non-qualified divided rate. Thus, although REITs are traded as stocks, they too are extremely tax-inefficient.

While stock funds are generally efficient, if they are actively managed and have a high turnover rate, it may be possible that they generate a lot of short-term capital gains. Likewise, a fund that pays high dividends (like many value funds do) may not be as efficient. Foreign funds typically are quite tax efficient since they are eligible for the foreign tax credit.

Spiegelman poses two hypothetical scenarios for two different investors. You can read his assumption on page 2 of the report, but the first case involves "Tishana" who is in the 40% combined marginal bracket and has a portfolio value starting at $200,000 (50% in taxable, 50% in tax-advantaged). In the first portfolio (Portfolio A), Tishana places her highly efficient stocks in her taxable accounts and her bonds in tax-advantaged accounts. In the second portfolio (Portfolio B), Tishana places her bonds in taxable and highly efficient stocks in tax-advantaged.

Years

Total Portfolio A

Total Portfolio B

Advantage (Disadvantage) of Portfolio A

5

$216,232

$204,087

$12,145

15

$387,030

$346,127

$40,903

30

$975,188

$846,486

$128,702

40

$1,841,668

$1,629,675

$211,993

As you can see in the above, Tishana would have more than $210,000 more in her final portfolio value after 40 years of investing if she practice tax-efficient placement of her investments. $210,000! That's certainly not an insignificant amount of money; it's more than her beginning portfolio value and more than 10% of her final portfolio value. Would you want to pay $200,000 more in taxes over 40 years simply because you don't want to practice tax-efficient investing? Of course not.

Next in the article, Spiegelman proposes a situation in which Tishana instead invests in actively managed stock funds in taxable and bonds in tax-advantaged. In that case, while Portfolio A outpaced Portfolio B in the 5, 15, and 30 year timelines, Portfolio B actually had the higher value after 40 years to the tune of $105,000. By the way, Portfolio A when utilizing actively managed funds ended at $1,524,169, a full $317,499 less than if Tishana had used tax-efficient index funds. And that's when assuming the actively managed fund performed identically to that of the index fund, something most actively managed funds fail to do. Even giving the active managers' the benefit of the doubt on that, the fund has to not only outperform the benchmark to break even because of higher fees, but also because of higher taxes. Yet another reason to go the passive approach! Again, such a decision could save you huge amounts over the long-term.

The article then discusses Sam who has a lower 30% combined marginal bracket. In Sam's case, the difference isn't as severe since he loses less to taxes in general so doesn't need to concern himself as much. Still, the advantage for Portfolio A when using over 40 years is $96,621, which is a quite considerable sum. In the case wherein Sam uses actively managed funds, Portfolio B outpaces Portfolio A after 30 years. Thus, if you absolutely insist on using actively managed funds (which I do not recommend), then you should consider the turnover and management strategy of the fund to determine the best placement, argues Spiegelman.

If an investor’s primary goal is to maximize after-tax return, then, in general, an optimal portfolio, from an asset location perspective, would hold broad-market index equity funds/ETFs or tax-managed equity funds in taxable accounts and taxable bond funds in tax deferred accounts. This assumes the investor is willing to forgo owning active equity funds (or other tax-inefficient investments), unless space in his or her tax-deferred registrations allows for it.

Jaconetti also proposes hypothetical scenarios similar to the Schwab study above to illustrate this point in real dollars. Such scenarios are helpful to the average investor to actually associate such decisions with real-dollar amounts as opposed to simply learning about these theoretical rules of thumb. All the same assumptions are made for the first three scenarios as stated on page 2 of the report.

In the first scenario, highly efficient index equity funds are used in taxable account and taxable bond funds are in tax-deferred. The post-liquidation value after 10 years is $1,694,671. In the second scenario, taxable bond funds are used in taxable accounts and index equity funds are used in tax-deferred accounts. In this case, the portfolio grows to $1,531,413. As you can see, this is considerably less than the first scenario. In the third scenario, the investor utilized municipal bond funds in taxable accounts (which are tax-free) and index equity funds in tax-deferred. Such an example grows to $1,583,088. While this is better than the second option, it still lags the first scenario considerably.

In scenario four, there are a few different assumptions as stated on page 4. In this case, the investor utilizes active equity funds in taxable and taxable bonds in tax-deferred accounts. Such an account has a post-liquidation value of $1,623,108 after 10 years. It is better than Scenarios 2 and 3 suggesting that even if you have actively managed funds, you should still place them in taxable. This conclusion seemingly contradicts that from Schwab, but if you look at the actual Schwab report, he came to the same conclusion for the 15-year timeframe (closest to the 10-year that Vanguard considered). It wasn't until 30 or even 40 years where the opposite conclusion was delivered. While scenario 4 beat scenarios 2 and 3, it still lags the first one. Yet another piece of evidence to support the idea of investing in index funds.

In the end, after ten years, Scenario 1 in which the investor utilizes tax-efficient index funds in taxable accounts and taxable bonds in tax-deferred performed the best after taking taxes into consideration. Scenario 2 lagged by more than $163,000, while Scenario 3 trailed by $111,583, and 4 was $71,563 behind, suggesting that such a location decision is less important for those implementing actively managed funds. As stated at the onset, scenario 1 optimizes returns.

Other Research Reports

Dammon, Poterba, Spatt, and Zhang from CMU, MIT, CMU, and UT-Dallas reached the same conclusion as the Vanguard report utilizing arbitrage arguments in their 2004 TIAA-CREF Paul A. Samuelson Award-winning paper, which they discuss in a research dialogue. They conclude:

Using arbitrage arguments, we showed that holding equities in taxable accounts
and bonds in tax-deferred accounts is the optimal asset location strategy even if capital gains are realized and taxed on an annual basis, as long as the tax rate on capital gains is less than that on interest income. This implies that even actively-managed mutual funds that generate large capital gains (losses) each year should be held in taxable accounts and bonds in tax-deferred accounts. The asset location decision is a matter of indifference only if capital gains are fully taxed each year (i.e., no deferral) and dividends, capital gains, and interest are all taxed at the same rate.

It appears that that Schwab came to a different conclusion as to where to place actively managed funds (and that's the only significant difference) than Vanguard and the above academics due to different assumptionsthat you cannot predict. (Although Schwab came to the same conclusion over shorter-time frames. Just not the 40-year hypothetical growth scenario).This is yet another reason to hold index funds - you know what you are getting and can manage it in a way to confidently minimize taxes. This much is sure, though - placing tax-efficient stock funds in taxable and bonds in tax-advantaged accounts is indisputable and can save you a boatload of cash. These investors also single out REITs as stock investments that make the most sense in tax-advantaged accounts. Of course, tax-exempt bonds should also be held in taxable accounts.

William Reichenstein, the Pat and Thomas R. Powers Chair in Investment Management at the
Hankamer School of Business at Baylor University, brings up yet another point in his paper "Asset Allocation and Asset Location Decisions Revisited." He concludes that not only is their an optimal asset locations as discussed above, but that the profession in general has been "miscalculating an individual's asset allocation, and the measurement error can be substantial. Asset allocation should reflect after-tax funds because goods and services are purchased with after-tax money." This is quite an interesting point that will be revisited in the future post, but I think it's important to note that if your tax-advantaged accounts are largely bonds and your taxable accounts are filled with stocks, then your intended asset allocation may actually be out of whack with the after-tax value of such investments and a tax-adjustment may be prudent.

To conduct such adjustment, simply multiple the pretax values in tax-deferred accounts (401k, Traditional IRA, etc. not Roth accounts) by 1 minus the expected tax rate during retirement. Taxable accounts are also subject to capital gains taxes so an adjustment there may also be wise (such as adjusting for the 15% long-term capital gains tax for your stock gains). There is still some debate in investment circles about this approach, though, and many state that investments don't care where they are housed and thus calculating asset allocation percentages by adjusting for taxes is unnecessary.

To get back to the main point of the post, Reichenstein holds somewhat of a morphed view of the Schwab report and TIAA-CREF award-winning paper above. While he agrees that bonds should be tax-advantaged and stocks should be in taxable accounts, he also posits that such a decision is much more important for a passive investor than to an active investor. He also concludes that if one absolutely insists on holding bonds in taxable accounts, then one should adjust his or her asset allocation to have a relatively large bond holding. That is, such decisions should not be made in a vacuum and instead the optimal asset allocation and asset location decisions should be made jointly.

In yet another paper published in February 2006, "Trends and Issues: Tax-Efficient Saving and Investing," Reichenstein highlights a few key points. The first being that individuals should maximize their contributions to tax-deferred and after-tax accounts as much as possible as they all "allow for tax-exempt growth on their after-tax values." He again brings up the point of miscalculating one's asset allocation by not adjusting for after-tax values and thus individuals "overstate the allocation to the dominant asset class held in tax-deferred accounts." This is the paper you should consult if you want a clear explanation as to how to calculate your "true asset allocation" as I briefly described above.

For a more simplified description of the above including various investment choices, one can consult the Bogleheads wiki article on this topic. The wiki summarizes the strategy as follows:

If you would have to hold a tax-inefficient fund in a taxable account, consider a more tax-efficient alternative, such as a stock index fund rather than an active fund.

There is also a helpful graphical representation of how efficient various asset classes are as reproduced below.

That is certainly a helpful graphic to refer to when making asset location decisions.

Conclusion

While devising an investment plan, establishing a reasonable asset allocation based on your risk tolerance, objectives, and timeline is probably the single most investment decision you can make. Security selection to minimize fees and optimize returns while fulfilling a particular asset class also is vital in your investment well-being. In addition to those two factors, however, the decision to implement a tax-efficient investment plan to minimize taxes has proven to provide a significantly larger nest egg. The effect of taxes on one's portfolio should not be understated and one must consider the tax-efficiency of their investments when considering asset location. This is certainly an area that is often neglected but shouldn't be as the ramifications are profound. Studies utilizing historical data on the distributions and capital gains of investments as well as the current tax laws in place lead to an overwhelming benefit to the investor to place taxable bonds in tax-advantaged accounts and highly efficient stock funds in taxable accounts. Notable exceptions to the stocks in taxable accounts include REITs and actively managed funds with high turnover.

The location of your investments is vital to minimize taxes and maximize your after-tax portfolio return. I can assure you that you won't be sorry for considering tax-efficiency in your investment plan. It could mean literally hundreds of thousands of dollars more in your name when all is said and done.

Schwab has reduced the expense ratio on its commission-free ETF offerings (currently only eight). Certainly the amounts we're talking about are not huge; it looks like Schwab is attempting to beat Vanguard by at least 0.01% on all its funds (which amounts to $1/yr for a $10,000 investment). The only fairly significant change is its emerging market ETF, which has been reduced to 0.25% from 0.35%. The rest have decreased by 0.02%.

Following is an updated comparison of ETF offerings from Schwab, Vanguard, iShares/Fidelity, and SPRDs, courtesy of Schwab. Obviously, they highlight their own offerings! Recall that the Schwab, Vanguard, and Fidelity customers can trade these ETFs without paying transaction charges. Schwab currently has 8 such offerings, Vanguard has 43, and Fidelity/iShares has 25:

Domestic Equity ETFs

Schwab

Vanguard

iShares

SPDRs

U.S. BROAD MARKET

0.06%
SCHB

0.07%
VTI

0.21%
IWV

0.21%
TMW

U.S. LARGE-CAP

0.08%
SCHX

0.12%
VV

0.09%
IVV

0.09%
SPY

U.S. LARGE-CAP GROWTH

0.13%
SCHG

0.14%
VUG

0.18%
IVW

0.20%
ELG

U.S. LARGE-CAP VALUE

0.13%
SCHV

0.14%
VTV

0.18%
IVE

0.21%
ELV

U.S. SMALL-CAP

0.13%
SCHA

0.14%
VB

0.20%
IJR

0.32%
DSC

International Equity ETFs

Schwab

Vanguard

iShares

SPDRs

INTERNATIONAL EQUITY

0.13%
SCHF

0.15%
VEA

0.35%
EFA

0.34%
CWI

INTERNATIONAL SMALL-CAP
EQUITY

0.35%
SCHC

0.40%
VSS

0.40%
SCZ

0.59%
GWX

EMERGING MARKETS EQUITY

0.25%
SCHE

0.27%
VWO

0.72%
EEM

0.59%
GMM

Source: Charles Schwab & Co

In the end, all three brokerage firms have ample low-cost offerings and the differences are negligible. I wouldn't move my money to Schwab simply because they currently have slightly lower expenses (which are subject to change and aren't significant to begin with, except for perhaps the SCHE / EEM difference). But it's certainly good news that the firms are continually trying to get our business by providing more low-cost offerings. The more competition, the better.

The bigger news to me that dropped back in April is that three Schwab bond ETFs are in the works. Schwab's largest obstacle in my mind for getting individual investors to have the entirety of their portfolio with them was the lack of diversified and inexpensive bond funds. Supposedly, they'll be offering a TIPS ETF, a short-term US Treasury fund, and an intermediate-term US Treasury fund. While those three pale in comparison to what Vanguard offers, most people could make a decent portfolio with them. You certainly could do much worse.

I was surfing the web and came across Jason Zweig's personal website, which has a wealth of interesting articles and insights. Zweig, a finance columnist for The Wall Street Journal, former senior writer for Money magazine, and the editor who added extensive commentary following each chapter in the 2003 revised version of Benjamin Graham's The Intelligent Investor, is definitely one of the "good guys" in the finance and personal investing world. He subscribes to the low-cost indexing approach that is far too uncommon among financial commentators these days.In any event, I came across his article "Get Smart About Sectors," published in December 2002 in Money. At first glance, this seems like a very un-Zweig-like article. Sector investing? Doesn't that increase risk and reduce diversification? Well, yeah, if you're simply investing in a sector because you think it's "hot" and your motivation is simply to optimize returns. Rather, Zweig's article proposes another motivating factor behind sector investing - to serve as a hedge against human capital. That is, your job. Particularly if you work in a high-risk industry, you may want to think about balancing that risk with your financial capital in a sector that correlates the least with your human capital. This is the basic tenet behind diversification; and Zweig argues that this strategy will help reduce risk and increase diversification.I have heard of this strategy in passing, but hadn't come across a detailed article such as Zweig's until now (despite the fact that it was published in 2002!). This premise certainly makes sense. Just ask those at Enron who loaded up on company stock (as a sidenote, I recommend keeping your company's stock holding as less than 5% of your net worth if at all possible). On page 2, you can consult a chart of the various sectors and which sector correlates the least with it. For example, if you work in mining, you might consider having a position in a utilities sector fund since it has the lowest correlation at -17. Zweig does not encourage moving into and out of sectors in an attempt to time the market's movements. Rather, he encourages a buy-and-hold long-term approach just as he does with typical index funds. Zweig comments that the average sector fund charges 1.74%. That "average" is an absurd fee and can be easily avoided. Perhaps they didn't exist at the time of the article, but you can gain access to any of these sectors through Select Sector SPDRs. They have an expense ratio of about 0.22% - a far cry from the 1.74% average. Another alternative if you don't want to go to the ETF route, is to use the Fidelity Select Funds, which are actively managed and charge about 1.0%, but only have a $2,500 minimum. (You must hold these for 30-days or will be charged a redemption fee.) Vanguard also has several sector specific funds and ETFs that are in the 0.25%-0.38% range, but some require a minimum investment of $25,000 and charge a redemption fee of 1% if held for less than one year. But, again, you're planning to hold it more than one year anyways, right? Consult each individual prospectus or fund page for details. Some are actively managed, while others are simply indexes. For example, here is one of the Energy funds.Just remember, it is not advisable to attempt to use sector investing as a means to outperform the market and move into and out of hot sectors every two months. (Although I did explore a sector rotation investing strategy in a post here. The conclusion basically was that any outperformance one experiences due to sector rotation can be attributed to higher risk and volatility. While during certain periods this strategy did outperform, there were other periods of significant underperformance. Volatility overall was much greater than simply holding the total market.)

In the end, the idea that sector funds can be used as a hedge against potential job loss and serve to further diversify your portfolio is an interesting one. I don't think this strategy is imperative for everybody to use by any means, but if you're in a particularly high-risk industry or have concerns about job security or pay raises, this strategy might be one to consider.

Update: There is a timely article that's worth a read about the importance of human capital and its relevance to risk-taking in one's investments in today's Wall Street Journal. The article, "How to Think Smarter About Risk," is written by Mosche Milevsky, an Associate Professor of Fianance at York University in Canada. While he doesn't talk about sector investing, he introduces the concept of "personal beta," advising individuals to consider how a drop in the stock market would affect their paycheck and how such risks should be considered when devising a portfolio. If you're an investment banker your earnings are more tied to the stock market and you may want to take fewer risks with the rest of your portfolio. On the other hand, if you're a nurse or tenured professor such market movements have little relevance and you may want to be more aggressive and in stocks with your financial capital. Interesting read!

In my Lazy Portfolios post, you'll notice that many of them overweight the small and value components. Why do investment advisors often recommend this approach? I thought it would be interesting to delve deeper into answering that question in this post.

Before going into details of the Three Factor Model, it's first important to have a brief understanding of the Capital Asset Pricing Model (CAPM) on which the Three Factor is largely based. CAPM basically only uses market risk (systemic and non-systemic) as a proxy for expected return. Its equation is Ra = Rf + Ba(Rm - Rf), where Rf is the risk free rate of return, Ba is the beta of the security, and Rm is the expected market return. Essentially, as explained by this equation, investors are compensated by risk as measured by beta and time value. As investopedia explains:

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas).

Fama and French Three Factor Model
Eugene Fama, a professor at Booth, and Kenneth French, a professor at Tuck, developed a model by which to further describe market behavior, expanding on the CAPM. They published their findings in the Journal of Finance in 1992 ("The Cross-Section of Expected Stock Returns") and provided more details a year later in the Journal of Financial Economics ("Common Risk Factors in the Returns on Stocks and Bonds"). While CAPM uses the single factor of beta to compare returns, Fama and French found that to be too simplistic of an approach and added both size and value as factors to the model. They found that historically stocks with high book-to-market ratios (i.e. value stocks) and small-cap stocks have performed better than the market at large. Thus, they simply added to the end of the CAPM equation expressions SMB ("small (market capitalization) minus big"), HML ("high (book-to-price ratio) minus low"), and alpha. This new equation accounts for the tendency of outperformance of these two factors and gives a better comparison tool for evaluating fund performance, among other uses.The important part of their findings to us as individual investors and the main take home message is value stocks tend to perform better than growth stocks and small caps typically outperform large cap companies. Thus, portfolios with a high percentage of small cap and value would result in a lower value using this model than the CAPM, since it adjusts downward on those two accords.

(click to enlarge)

As you can see from the above chart courtesy of the New York Times (who used Fama and French's data), since 1926 small-cap value companies have hugely outperformed large-cap growth firms. Note that this is on a logarithmic scale and not linear, so the outperformance doesn't look as dramatic as it could. But this is a nearly a 100-fold (or 10,000%) difference!

Here is another chart from Index Funds Advisors, showing the growth of $1 from 1928 to 2007. The annualized return is on the y-axis while risk in the form of standard deviation is on the x-axis. Small-value experienced a 14.6% annualized return (albeit with higher risk) while large-growth had a 9.6% annualized return through December 2004. One interesting datapoint on this chart is small-growth, which has historically had relatively weak returns with a high standard deviation.

(click to enlarge)

Source: Index Funds Advisors

Small-Value Premium

Not only do small-cap and value plays have higher expected return, but they also provide additional diversification.While one may think that simply "owning the entire market" is as diversified as one can get in US equities, the weighting mechanism that indices use is "a far different outcome from what one would expect," explains Larry Swedrow in What Wall Street Doesn't Want You to Know. "Almost 70% of the portfolio is large-cap growth stocks." He recommends putting a large percentage of the portfolio in small-cap or value funds to compensate for this perhaps seemingly bizarre weighting. When your large-cap growth zigs, your small-cap or value holdings may zag, enabling you to sustain performance even in bearish times. Of course, these asset classes aren't perfectly negatively correlated so it's not going to be a flawless zig/zag relationship (nothing is unless you're shorting and long in the same position, which would be pretty pointless), but at least it presumably provides protection against the downside while at the same time increasing your expected return. A double win!As stated above with the Fama French Model, but it doesn't hurt to emphasize this point, since small-caps and value typically carry larger risks, the expected return must be greater to compensate. This is the small-value premium that people seek.

What this means for your portfolio

Personally, I think it makes the most sense for individual investors to simply hold small-cap value and ignore small-blend and large value. I find this simplified approach meets the desired results and is easier to hold and maintain in a tax efficient manner. Some aggressive investors prefer a 50/50 split between total stock and small-value. I personally like approximately a 2:1 total stock to small value ratio. Value, small-cap, and small-cap value funds are typically less tax efficient than a total stock market fund counterpart, so it probably makes sense to hold the small-cap value in retirement accounts. Although examining the tax cost ratio via Morningstar of a fund like VISVX (Vanguard Small-Cap Value Index) shows the difference is negligible (in fact, VISVX seems to be more tax efficient than VTSMX over certain periods) , so holding it in taxable account certainly isn't the worst thing you could do.Remember the media calling 2000-2010 the "lost decade" as the S&P was virtually unchanged? Well, if you had invested a considerable sum in small-cap value, your portfolio would be in seriously positive territory for that period. Not so lost anymore! From January 14, 2000 to June 10, 2010 (today), Vanguard Total Stock Market is down nearly 17%. It certainly would seem like a waste of investments if that was your return after 10 whole years. VISVX, on the other hand, is up 64% over the same period - an outperformance of 81%! And you thought those timing strategies had good outperformance. This strategy simply calls for setting a slightly different asset allocation and letting it be (which is much more tax efficient) and absolutely obliterated more complicated, tax-inefficient strategies.Let's take a look at the growth of $10,000 chart of Total Stock Market and Small-Cap Value since June 1998. The blue line is total stock, while the orange line is small value.

(Source: Morningstar Inc.)

As you can see, from 1998 to mid-2000, the total stock market largely outpeformed small-cap value as tech growth stocks were all the rage and escalated in value like no other time in history. When the tech bubble burst in 2000, though, you'd certainly be glad you had small-cap value to provide diversification and to offset some risk. In the 2000 to January 2003 period, the total stock market plummeted 36%, while small-cap value enjoyed a small (but real) 4% gain. That is the zig/zag action we were talking about earlier. The 1998-2003 timeframe illustrates this diversification benefit perfectly. While the total stock market took you on a roller coaster ride (where your $10,000 grew to $13,000 before falling to $8,000), small-cap value had a different trajectory and would have somewhat abated that volatility (for both the upside and downside).In the end, after twelve years your $10,000 invested in VTSMX grew to nearly $12,000, while small-cap value blossomed to nearly $19,500. That's the small-cap premium we're looking for!
Just as a comparision, here is a chart comparing total stock (blue) with value (yellow), small blend (green), and small-value (orange). As you can see (although this won't always be the case), small-value really provides the best of both worlds in the Fama French model.

(Source: Morningstar Inc.)

The Value Index largely mirrored total stock (although provided some refuge during the growth uprun and demolition from 1998-2003), while small-blend provided more diversification, and small-value gave even a larger return due to its premium.This strategy should be in the arsenal of all indexing individual investors. Small-cap value provides greater expected return and increased diversification with the caveat that one should expect slightly more volatility and risk.Edit: DIY Investor brought up a good point in the comments that investors with lower risk tolerances (e.g. retirees) might want to think twice before "loading up" on these asset classes based on the downside risk, standard deviation, and volatility measures. I certainly agree and probably should have mentioned this above as there is certainly is increased risk in these asset classes. However, as I responded, I think investors are more than amply compensated for the additional risk. A retiree with a 40/60 equities/bonds portfolio might have something like 20% Total US, 10% Foreign, and 10% US Small Value based on my proposed 2:1 US Total to small value. 10% Small-Value, even with its volatility, is not going to wreak havoc on that portfolio and would marginally increase your risk (while correspondingly increasing your expected return). Looking at the alpha measures of VISVX (quite simply, a risk-adjusted measure of performance; of course, past performance doesn't guarantee future results), VISVX has a 3-year alpha of 6.68 (with a beta of 1.28) and a 1-year alpha of 6.68. That is, VISVX has enjoyed nearly a 7% outperformance (annually) of what CAPM would predict (i.e. after taking risk/beta/volatility into account). VTSMX, for comparison has an alpha of 1.18 (and beta of 1.03, as expected). As stated, this doesn't guarantee anything for the future, but historically the alpha values for small-value are favorable and investors have been more than compensated for the increased risk. But, it is important to stress, that the increased risk is real, so you should take this into account if you plan to dip in this asset class.

Update 6/16/10: Larry Swedroe's recent article on why the Small Growth Index is the "Black Hole of Investing." That's why I avoid it all together.

Wikinvest Wire

Disclaimer: Effort is undertaken to ensure that information contained in this blog is accurate and up-to-date. However, there is no guarantee that everything is without error. Investing involves risks. Advice and analysis on this site should not be construed as input from a financial adviser. Past performance does not guarantee future results. The return and principal value of any investment fluctuates with time and an investment may be worth less at the time of sale than the original cost. Investors should carefully consider their own objectives and risks when making investing choices.